UNIVERSITY OF BOMBAY

DEPARTMENT OF ECONOMICS

THEORIES OF STATE INTERVENTION

BY
AJIT KARNIK

WORKING PAPER 96/11

MAY 189S
 THEORIES OF STATE INTERVENTION

AJIT KARNIK
Department of Economics
University of Bombay

ABSTRACT

In this paper we are interested in examining the.

Various theoretical approaches to State intervention that
have been offered by different schools of thought Such an
exercise assumes importance in a world situation when a
large number of societies are going through a painful
transition process. We do not concern ourselves with
discussing the specific situation of any particular
economy in transition while seeking to delineate the role of
the State. Even though the latter is an interesting exercise,
our objective here is to identify general principles in the
pursuit of redefining the role of the State. Four different
approaches towards State intervention have been discussed in
the paper: neo-classical, public choice, transactions costs
and information theoretic. The essential features of each
of these approaches have been studied and compared with one
another.
 THEORIES OF STATE INTERVENTION

Ajit Karnik
Department of Economics
University of Bombay

1 . INTRODUCTION

In recent years there has been a major revaluation of the

role that the State is expected play in a modern economy. World
events have necessitated this revaluation. For a long time two
paradigms dominated the discussion regarding the role of the
Stace: at one extreme was the so-called capitalist model with a
very limited role for the State and at the other extreme was the
centralised planning paradigm with a very limited role for
markets. The capitalist model, in its classical form, gave
primacy to the markets with minimal interference 'from the State;
in fact the State was expected to be a weak State operating in a
The experiences of Chile in Latin America and the East Asian
miracle countries challenged this classical capitalist model.
Even though in these economies the markets were, by and large,
free and private enterprise dominated, the State was far from
weak. In fact, in at least some of these countries, absence of
democracy may have contributed to their success. The East Asian
countries in a sense created a new paradigm: the managed
capitalist economy. Under this new paradigm the role of the State
had to be redefined so different was it from the role envisaged
under the classical capitalist system.

* Much of the research related to this paper was done during two
terms spent at St. John's College, Cambridge, UK in 1995. The
generosity of the College and the support and hospitality of
Jeremy Edwards is gratefully acknowledged.
At the other and of the spectrum even greater cataclysmic
changes were taking place. Moat of the rigidly planned economies
of Eastern Europe, including the Soviet Union, went through a
crisis which made a move away from the earlier system almost
Inevitable. In all of these countries as well the role of the
State had to be redefined. In fact, in most of these countries
Where the transition was vary sudden, the old State had
disappeared and the new recreated State was not even in place.
This interregnum was marked, in some cases at least, by a descent
into a virtual state of nature.

In this paper we are interested in examining the various

theoretical approaches to State intervention that have been
offered by various schools of thought. Such an exercise assumes
importance in a world situation when a large number of societies
at re going through a painful transition process. We do not concern
ourselves with discussing the specific situation of any
particular economy in transition while seek! g to delineate the
role of the State. Even though the latter is an interesting
exercise, our objective here is to identify general principles in
the pursuit of redefining the role of the State.

The plan of the paper is as follows: We have a total of 8

sections, including this one. In the next section, that is,
section 2 we look at the political philosophy issues underlying
the social organsiation in the context of which State
intervention is posited. Section 3 begins the discussion on the
theories of State intervention, the first of which, the neo-
classical approach, is examined in section 4. Section 5 looks at
the public choice approach while section 6 discuss the
transactions cost or institutional approach towards State
intervention. In section 7 we look at the information theoretic
approach to State intervention. Finally, section 8 compares the
various approaches towards State intervention and offers some
concluding remarks.

2
 2.ISSUES IN POLITICAL PHILOSOPHY

The issue of the role of the State is closely connected with the social
organisation within which the State to presumed to exit.
The social organisation that is envisaged for
society should conceivably form a continuum from the
minimalist or l i b e r t a r i a n v i e w p o i n t t o t h e
m a x i m a l i s t o r c o l l e c t i v i s t viewpoint. However,
from the point of view of analysis the following
taxonomy of a theory of society seems appealing:

1)Libertarian

2)Liberal

3) Collectivist.

Libertarian View

According to the Natural Rights Libertarians State

intervention is morally wrong except in very limited
circumstances. For Nozick (1974) a minimal State, limited to
the narrow functions of protection against force, theft and
fraud, enforcement of contracts and so on, is justified;
any more extensive. State will violate persons' rights
not to be forced to do certain things and is unjustified.
This proposition indicates the libertarian predilection
for a night-watchman State. Such a State can have no
legitimate distributional role except in correcting past
wrongs. It is surprising that, not only would Nosick's
approach oppose redistribution in a Pareto efficient
framework, but also oppose all Pareto improving State
Intervention (Atkinson and Stiglitz, 1989), Such Pareto
improving intervention can make a person better off without
making anyone else worse off; there is thus no
redistribution involved and hence no infringement of any
individual’s liberty. The Empirical Libertarian approach, of
which Hayek (1960) is an important contributor, has three
strands the primacy of
Individual freedom, the value of the market mechanism and the
assertion that the pursuit of social justice is not only
fruitless but actively harmful because it can end up destroying
individual liberty. Similar views can be attributed to Friedman
(1962) Who believes like Hayek, that the State has no
distributional role, other than for certain public goods and for
strictly limited measures to alleviate destitution.

Liberal View
Two notions of liberalism may be distinguished:
utilitarianism and Rawlsian.

The Utilitarian aim is to distribute goods so as to maximise

total welfare. Goods may be interpreted broadly to cover goods
and services, rights, freedom and political power. Maximising
includes the following: goods must be produced and allocated
efficiently and they must be distributed according to the
principles of equity.

Rawls (1972) is the liberal counterpart of Nozick: for him

the natural right and hence the prime aim of institutions is
social justice. Thus each person possesses an inviolability
founded on justice that even the welfare of society as a whole
cannot over-ride. Justice for Rawls has a two-fold purpose: it is
desirable for its own sake; but also institutions will survive
only if they are perceived to be just. The resulting principles
of justice deal with the distribution of economic goods, as well
as position, opportunity, skill, liberty and self-respect.

Collectivist View

Twos variants of this view may be distinguished: Fabian

Socialism and Marxism.

The Fabian Socialists agree on the importance of equality,

but freedom and fraternity are also important. They consider
resources as available for collective use and consequently favour
government action. However, there has been some disagreement
about whether socialist goals could be achieved within a market
order

Marxist share with the Fabian Socialist a belief in equality,

freedom, and fraternity. This view clearly calls for a highly active
role of the government. It stresses the importance of State
ownership of the means of production since private ownership of
productive assets is incompatible with the Marxist definition of
freedom.

3. THEORIES OT STATE IHTERVENTIOM

The conception of society that one visualises is important

from the point of view of examining the theories of State
intervention. A society based on minimalist, libertarian
principles severely constrain State intervention: once the basic
public good, defense, has been provided, no further State
intervention can be justified. The immorality of any further State
intervention is axiomatic. On the other hand, a society based on
collectivist principles completely rejects the market and the
operations of the State are all pervasive. The position of the
collectivist is in a sense a mirror image of the libertarian
position: the failures of the market are seen to be axiomatic.
Neither of these approaches, either libertarian or collectivist,
allows for a piecemeal approach towards State intervention. Such
an approach is, however, consistent with a liberal view of society;
that is, a society in which neither the market nor the State is
sacrosanct. It is well accepted that both the market and the
government may fail. Further, both, the market and the State are
viewed as means to an end the end being maximisation of social
welfare.

We shall be examining the following approaches towards State

intervention:

5
 1. Neo-classical approach

2. Public choice approach

3.Transactions costs approach

4.Information theoretic approach

4• NEO-CLASSICAL APPROACH

The starting point for a neo-classical theory of State

Intervention is the two Fundamental Theorems of Welfare
Economics. The First Theorem states that, subject to certain
assumptions, a general equilibrium, if it exists, will be Pareto
efficient. These assumptions are perfect competition, absence of
public goods and externalities, absence of non-convexities in
production and consumption and perfect information. The Second
Theorem, subject to these assumption, plus the assumption of the
availability of lump-sum taxes and transfers to the government,
states that any Pareto efficient allocation can be achieved as a
solution to a general equilibrium system.

The Second Theorem provides a limited role for State

Intervention: the State can intervene only by employing lump sum
taxes and transfers. Thus the intervention is one, which does
not distort decision making on the part of economic agents
since lumpsum taxes have only an income effect but no
substitution effect. It is important that even this limited
intervention by the State would be considered an infringement
of individual freedom by the libertarians. The government
employing lump-sum taxes and transfers relocates individuals on
the contract curve and in the process carries out a re-
distributive activity. Such a re-distributive activity would be
permissible according to the libertarians only if the initial
endowments of the better off individuals were acquired
illegally. The State could then, invoking the principle of
rectification, intervene in order to carry out this limited
redistributive activity. All other forms

6
of redistributive activity are illegitimate and
taxation is considered by Nozick to be theft (since it
extracts money from people they would otherwise have
allocated, differently)and slavery (since people are
forced to spend a part of their time working for the
government)(Barr, 1993).

An economy characterised by the assumptions of the

two theorems, including the availability of lump-sum
taxes and transfers, is known as a first best
economy. A violation of any of the assumptions of
these theorems leads to second best sit uations and
is broadly labeled as the breakdown of the
efficiency conditions. Atkinson and Stiglitz, 1989).
Among <all the efficiency conditions that fail to
hold, neo-classical economics focuses on what are
called instances of market failure, as the rationale
for State intervention. The State intervenes in the
market economy to correct such market failures. It
is possible to trace back the mainstream theory of
State intervention to Adam Smith who proposed the.
following three duties for the State:

1.protecting society from violence and aggression

2. protecting every member of society from injustice

and oppression

3. erecting and maintaining certain public works and

public institutions, which will not be erected and
maintained by individuals.

Neoclassical theory taking its cue from smith's

third duty of the State, identifies the existence of
public and quasi-public good as an important cause of
market failure. Public goods are characterised by non-
rivalness (in consumption) and non-exclusion which makes
private provision impossible. Free riding on the part
of consumers will mean that no positive price will be
volunteered for the benefits of the public good; such
benefits, due to non-exclusion, will be available to all
individuals.Non-rivalness,
On the other hand, implies zero marginal cost: of additional Adviser
this weans that marginal cost pricing will not cover the cost of
producing and providing the public good. The market will fail in the
presence of pure public goods and such goods will not be provided
by the market at all. Examples of pure puilic goods are legal
system, national defense and efficient government. Quasi-public
goods,such as transport system,education, research and
development, often being too expensive for an individual to produce
and make a profit, will be under-provided and would, under certain
circumstances, require State intervention,

Other reasons for the failure of the market are:

1. presence of externalities

2.presence of oligopolistic and monopolistic market structures

3. presence of distributional inequalities.

Externalities are interdependencies that operate outside the

Market or price mechanism and give rise to a discrepancy between
private and social benefits. In such a situation Pareto
efficiency cannot be achieved even in the presence of competitive
markets. The presence of monopolies and oligopolies implies that
prices will be set above marginal costs leading to re-
distribution from consumers to producers. Such re-distribution
raises the possibility of severe distributional inequalities.

State intervention in the presence of externalities takes the

form of Pigouvian taxes and subsidies: taxes being imposed on
activities which involve a social cost greater than the private
coat and subsidies being provided for activities which involve a
social benefit over and above the private benefit. On the other
hand, the presence of monopolies and monopoly practices calls for
State intervention in the form of anti-trust legislation or
regulation on monopoly pricing.

8
 The broad picture of the role of the State that emerces in
the neo-classical framework is that of piecemeal intervention in
general, markets are assumed to function efficiently i.e.
allocate resources efficiently, coupled with localised market
failures which calls for a limited State intervention. This, is
state intervention in pursuit of efficiency in resource
allocation. On the other hand State intervention on grounds of
equity is justified only via the second Fundamental Theorem of
Welfare Economics. However, provision of certain quasi-public
goods may have an equity dimension as well eg. provision of free
or subsidised education. In summary, the existence of the State
and a meaningful role for it depends on the pre-existence of
markets along with a failure of some segments of the markets.

The only objective of the State in the neo-classical

framework, is the maximisation of social welfare. The State will
intervene only to correct market inefficiencies which impinge on
social welfare. The State thus has no other objectives which
might conflict with the objective of maximising the welfare of
its constituents viz. the consumers. In the terminology of agency
theory, consumers are the principals whose welfare is maximised
toy its agent, the State. Since there is no divergence between the
objectives of the principal and the agent, there is no question
of a conflict between the two. The actions of the agent do not
have to be monitored by the principals to ensure that social
welfare is being, in fact, maximised. In any case, in the static
neo-classical theory there is perfect information, all of which
is conveyed by market prices. Thus, problems associated with
asymmetry of information between the agent and the principal
simply do not arise.

5. PUBLIC CHOICE APPROACH

In stark contrast to the Neoclassical approach, the

Public Choice approach regards the State as resulting
spontaneously from a state of nature; it regards the State
functionaries as the

9
 principal of the State and suggests that the objectives of these
principal is to maximise their own utility; this leads to State
partiality in favour of certain groups as well as inefficiently
h i g h levels or outputs and supply which drives growth of the
State sector.

The emergence of the State is analysed by

Mueller (1989)in the context of gain from
trade within a Prisoner's Dilemma f r a m e w o r k .
The following matrix (Matrix 5.1) emerges
f r o m a simple society of 2 individuals.

MATRIX 5 . 1: PRISONER’S DILEMMA GAME

A B Co-operates Does not Co-operate

Co-operates (1) 10,9 (4) 7,11

Does not co- (2) 12,6 (3) 8,8

operate

The invisible hand of Smith seems to suggest that individuals,

out of pure self interest, will trade i.e. be in call (1), with both
adopting a co-operative strategy. However, in single plays of the
game (or even if the game is repeated a known number of times) the
Nash equilibrium will be in cell (3) with both players adopting the
non-co-operative strategy. Despite the obvious gains from trade (the
move from cell (3) to cell (1) is Pareto improving) the co-
operative strategies do not constitute an equilibrium pair. The
distribution of utilities that obtains is the one that would emerge
in a Hobbesian State of Nature (Mueller, 1989, p.10). From this
state of nature, both players become better off by tacitly or
formally agreeing not to steal. Such an agreement between individuals
could be called a "constitutional contract" establishing
property rights and

10
 behavioural constraints on each Individual.

The evolution of co-operation may occur in the context of a

prisoner's Dilemma Supergame which is played out an infinite number
of times (Mueller, 1989) or via a punishment/tit-for-tat strategy
(Axolrod, 1984). The Public Choice school believes that the State
comes into existence non-deliberately: it is a result no agent
intended, but is one that no agent or group of agents would rather
do without (Schotter, 1981). Such an approach to the State solves two
problems relating to the pure neo-classical tradition:one,a
mechanise for deriving the general will is found; two, the
mechanism generates institutions such as the State, without
simultaneously requiring the pre-existence (and failure) of other
institutions such as the market (Pitelis, 1993, p.108) .

The co-operative solution observed in a Prisoner' Dilemma game

is dependent on the number of players involved. The larger the
number of players the more difficult it becomes to monitor behaviour
and detect uncooperative acts. In such a situation, an institution
such as the State with its "legitimate* monopoly of force may play
the policeman and enforce co-operative behaviour. A counter to this
proposition is the argument that State intervention "frees" the
individual from responsibility leading to further defection from co-
operative behaviour, calling for further State intervention. The
process becomes self-reinforcing and has been cited as one
possible explanation for rising government expenditures (Mueller,
1989).

In a 2-person situation, when a constitutional contract is

agreed upon, a society is born, but a State (as an enforcing
agency) is not required. Defection from co-operative, in a 2-person
society, is easily detected: there is perfect information. As the
number of persons increased beyond 2, information and knowledge
about the actions of individuals becomes uncertain. Free riding,
without detection/identification, would become a distinct
possibility. Society in the sense of a constitution

11
 would continue ho exist, but now a monitoring agency is
required. thus proposition being made is that, if their are
only two players, a State is not required; if this number
rises to three as individual will be unable to know precisely, in
the event of a shortfall. in the contribution towards provision
of the public good, which of the other two players has
defected from co-operative behaviour. This knowledge becomes
increasingly fuzzy as tie number of players increases
further. Clearly a monitoring agency is required when the
number of players increases beyond two if the monitoring
agency also has powers to enforce co-operative behaviour,
a State has coma into existence in the context of the
Prisoner's Dilemma game.

As the number of players increases and as

detection/identification of free riding becomes more
difficult, the extent of free riding would increase. Rarely
will it be the case that a society will collapse to cell (3),
i.e., collapse to a state of nature, if an insignificant
minority reneges on cooperative behaviour. Such a collapse
to cell (3) implies that society is so fragile that even a
single defection from co-operative behaviour will set in
motion a process whereby everyone defects from co-operative
behaviour and the society sinks into a state of nature. In
the context of public goods provision, defection of a
minority of players from co-operative behaviour will rarely
lead to complete non-availability of such goods very few
public goods have the property that they can be provided if
and only if all individuals contribute towards provision.
Such a situation, In effect, places a veto power in the
hands of each Individual. Besides, with a large number of
individuals, the contribution each individual is so small
that the shortfall in total collection will not affect
availability of the public good, so long as a significant
proportion of individuals do not defect from co-operative
behaviour. What will however happen is that there will be a
re-distribution of welfare from the contributing member to
non-contributing members. Such a situation can be modeled by
alternative game situation viz. the game of chicken (Matrix 5.2)

12
 Matrix 5.2 GAME OF CHICKEN

A B Co-operates Does not

Co-operate

Co-operates (1) 3,3 (4) 2,3.5

Does not co- (2) 3.5,2 (3) 1,1

operate

The distribution of utilities in the 4 cells of the game of

chicken is such that for the row player the following holds:

cell (2) > cell (1)> cell (4) > cell (3)

It may be noted that for the Prisoner's Dilemma game

the distribution of utilities leads to the following ranking
for "the row player:

cell (2) > cell (1) > cell (3) > cell (4)

The main difference in the ranking of cells between the

two games is that the position of cell (3) and cell (4)
is interchanged in going from one game to the other. Thus
in the Game of Chicken the players value the public good so
much that each is willing to contribute even if the other
does not. Thus the availability of the public good does not
cease even when agents defect from co-operative behaviour.
This is a situation where the utility of being in a society
exceeds the disutility of non-cooperative behaviour of some
individuals. By all experience this seems a more realistic
way of characterising a society than the Prisoner's Dilemma
Game. Most members of society continue to be law or
convention-abiding even when a minority, possibly not
miniscule, contravenes the law or the conventions of society
and appropriates undue benefits.

13
 In either of the game situations the State may emerge to
monitor the actions of individuals and it may emerge as
a sequence of human design. This is contrary to Hayek's (1976)
who considers institutions to be the result of human actions,but
not of human design.

The Public Choice school differs from the neoclassical

paradigm in one other important respect. Neo-classical theory
assumes that States maximise social welfare. According to Public
Choice theory State functionaries are assumed to maximise their
own personal interest, as does every rational economic agent
(Schumpeter, 1942, Downs, 1957, Niskanen, 1973, Nordhaus, 1973,
Mueller, 1989). In the terminology of agency theory, the
principals in the neoclassical analysis were the consumers whose
welfare is maximised by the State, acting as the agent of the
principals. According to the Public Choice perspective the State
is itself the principal, 3eeking to maximise the welfare of its
functionaries. This feature of the Public Choice approach raises
the possibility that the State will not be a neutral participant
in the economic process, but may favour sectional interest in
order to further its own welfare. Legislation favouring powerful
interest groups may be passed in return for financial and voting
support. This deflection of the maximisation process from social
welfare to State functionaries' welfare may not necessarily evoke
a reaction from the majority because of "optimal ignorance". This
is a situation where the cost of obtaining information concerning
State action is equal to or exceeds the costs of remaining
ignorant (Cullis and Jones, 1987).

6. TRANSACTIONS Cost APPROACH

The Coase "theorem* suggests that market failures by

themselves need not result in State intervention if individuals
can internalize such imperfections. Coase (1960) puts forward the
proposition that if the State establishes clear property rights,
then any externalities that emerge in the market can be
 internalised by economic agents. If further public goods and
monopolies can be seen as instances of externalities, then the
State has no role to play except in establishing property right
Of course, the results of the Coase theorem rests on
whether individuals can actually internalize externalities
costlessly, cooter (1989) indicates that this will be
unlikely in the presence of transactions costs.

The starting point for an analysis of transactions costs is

Coase (1937). This work of Coase explains why firms exist and
also makes a conceptual distinction between the firs and the
market. The key feature of the firm is its internal suppression
of the price mechanism and the allocation of resources within the
firm by command rather than through prices. The main reason why It
is profitable to establish a firm would seem to be that there is
cost of using the price mechanism.. .it is true that contracts are
not eliminated when there is a firm but that they are greatly
reduced. K factor of production (or the owner thereof) does not
have to make a series of contracts with the factors with whom he
is co-operating within the firm, as would be necessary, of
course, if this co-operation were a direct result of the working
of the price mechanism* (Coase, 1937, p.390-391).

Following from this approach Williamson (1985, p.l) hay

developed his central thesis that economic institutions (such as
the firm) have the main purpose and effect of economizing on
transactions costs. However, even though the term transactions
cost is used widely it lacks a clear definition (Hodgson, 1993,
p.81). Williamson (1985, p.19) has called these costs the
economic equivalent of friction in physical systems; Arrow (1969,
p.48) defines transactions costs as the costs of running the
economic systems. In similar vein Cheung (1993, p.51) describes
transactions costs as all those costs that cannot be conceived to
exist in a Robinson Crusoe economy. Thus, these costs will
include costs of contracting and negotiating, measuring and
policing property rights, of monitoring performances and of
organizing activities,

15
With this understanding of transactions it is possible to
analyse market failures more systematically and build up a
rationale for State intervention. Proceeding from his 1937 paper
case (1960) views market failure as arising due transactions
case:

"In order to carry out a market transaction it is

necessary to discover who it is that one wishes to
deal with, to inform people that one wishes to deal and
on what terms, to conduct negotiations leading up to a
bargain, to draw up the contract, to undertake the
inspection heeded to make sure that the terms of the
contract are being observed and so on. These
operations are often extremely costly, sufficiently
costly at any rate, to prevent many transactions that
would be carried in a world in which the price system
worked without cost* (p.15).

The firm emerges as an institution designed to overcome

these transactions costs, though it is not the only institution so
designed. An alternative to the firm is government regulation,
which can influence the way in which factors of production are
used. The government is thus a super-firm of a very special kind
(Coase, 1960, p.16). The government is different from the firm in
that it can avoid the market and forces of competition
altogether, which a firm can never do. Further, the government
with the enormous powers at its disposal can get things done at
lower cost than can a private organisation.

Arrow (1970) states that transactions costs are associated

with any mode of resource allocation including the market. Market
failure is the particular case where the transactions costs are
so high that the existence of markets is no longer worthwhile
(Arrow, 1970, p. 68). There are two main sources of transactions
costs: exclusion costs, which get to be prohibitively high in the
case of public goods and costs of communication and information.

16
 The existence of the latter coats is an implicit admission that
prices do not convey all information that may be necessary to
carry out a transaction. A third type of transactions cost is '
noted: costs of "disequilibrium*. These costs may arise even under
perfect information since it takes time to complete the optimal
allocation and either transactions take place which are
inconsistent with the final equilibrium or they are delayed until
the computation is completed (Arrow, 1970, p.68). In the timeless
Walrasian general equilibrium, disequilibrium costs are non-
existent since no transactions take place except at equilibrium
prices; it is the explicit allowance for the passage of time that
leads to disequilibrium costs. Arrow concludes like Coase that
"the State may frequently have a special role to play in resource
allocation because, by its nature, it has monopoly of coercive
power and coercive power can be used to economise on transactions
costs" (Arrow, 1970, p.69).

The reasons for the existence of transactions coats have

been noted by Williamson (1985) to be bounded rationality.
opportunism and asset specificity. Noting the divergences between
neoclassical economics and transactions costs will help.
Neoclassical economics makes the behavioural assumption of
maximising which is unobjectionable if the relevant costs are
taken into account. This however is not done and the role of
institutions is suppressed: firms are productions functions,
consumers are utility functions and optimising is all pervasive.
The device of contingent commodities which is employed in Arrow-
Debreu models permits comprehensive inter-temporal trading
without the need for contracting. Bounded rationality is the
guiding assumption of transactions coats economics: as noted by
Simon (1961) economic agents are intendedly rational but only
limitedly so. With rationality being bounded, costs of planning,
adapting and monitoring transactions need expressly to be
considered.

The level of self orientation differs in neo-classical

economics from the transactions costs economics. The self-

17
nearest seeking neoclassical economic agent plays the game by
the rules which have already been fixed and there is no deviation
from this rule based behaviour. In transactions costs economics,
agents are characterised by opportunism. Which is self interest
seeking with guile (Williamson, 1985, p.47). This obviously means
that even if there were rules of the game, these may be broken:
thus lying, stealing, cheating along with more subtle forms of
opportunism are permitted. The notions of moral hazard and
adverse selection in the insurance literature already incorporate
the notions of opportunism. In essence what these two notions
involve and what underlies the notion of opportunism is a
cordition of informational asymmetry.

Specificity of assets introduces imponderables into

contracts in a way that is not conceivable in neo-classical
economics. Asset specificity includes specificity in physical
assets, human assets,location and dedicated, assets. The
existence of non-salvageable, i.e. capable of being used in
alternative employment, characteristics in an asset introduces
impediments in a transaction, which is not the case with
neoclassical nonspecific assets. Thus neoclassical transactions
can take place within markets where faceless buyers and sellers
exchange standardised goods at equilibrium prices.

The transactions costs arising from bounded rationality,

opportunism and asset specificity lead to instances of market
failure and in such cases as well the coercive powers of the
State could help economise on such transactions costs. Thus the
neoclassical rationale for State intervention is generalised via
the transactions costs approach. Transactions costs become the
general pause of market failures and economising on transactions
costs is the prime reason for the existence of the State.

There is however one problem with this transactions costs

rationale for the existence of the State. As per Coase (1937),
firms exist to minimise the transactions costs associated with
using the market or the price mechanism; however firms cannot

18
avoid the market altogether, though the state can. given this and the
fact that the State can economise on transactions costs more
efficiently through its coercive powers, why does not the State
replace both the firm and the market? The answer lies in the fact
that no solution can be costless. There is no reason to believe
that government regulation will not worsen the problem of market
failure or even possibly introduce failures of another kind. The
literature in public choice is replete with instance of
government failure. This is the reason why firms and markets
continue to exist in the presence of government or regulation
even though the coercive powers of the government may lend it an
edge in terms of efficiency in resource allocation.

In view of the fact that all institutions, market, firms and

governments involve transactions costs in their operations, no
single institution can displace the others. Transactions costs in
the use of the market mechanism, leads to firms; firms may also
fail and involve high transactions costs; the failure of markets
and firms - private sector failure - leads to State intervention,
which itself maybe beset by government failure. Government
failure could be seen as the combined result of bounded
rationality and opportunism on the part of State functionaries,
giving rise to excessive transactions costs (Williamson, 1985) .
Opportunism of State functionaries arises from the possibility of
exercising the vast discretionary powers that are at the disposal at
the State. Both kinds of State functionaries, elected or non-
elected, are capable of such opportunism, which results in the
manipulation of the economy for partisan ends or leads to a quid
pro quo between State functionaries and interest groups. The net
result of such opportunism is that State intervention, which was
initiated to efficiently allocate resources in the presence of
market failures itself, leads to a further mis-allocation of
resources. Thus market failure, which was the original cause of
State intervention, persists and to that is added a further kind
of failure in the allocation of resource, namely, government
failure. Such government failure adds further to the transactions
costs which were the primary cause of market failure. The failure

19
 of both, the State and market, thus results in institutional
failure. Given the failure of all institutions to perform certain
transactions economically, the right mix would have to be chosen on
the basis of overall transactions cost* minimisation.

North (1981) puts together the neoclassical and public

choice Ideas to produce a unified theory of State Intervention. In
North's model a utility maximising ruler is assumed who trades
services such as protection and justice in return for revenue that
is collected from the subjects. This ruler acts as a
discriminating monopolist b1' devising property rights for each so as
to maximise State revenue, subject to the constraint of
potential entry by rivals providing the same services and
motivated by the same concerns. Such rivalry may be situated in a
democratic context where competing political parties vie for
electoral favour; alternatively, in a non-democratic context, the
competition for political power may be less elegant, in any
event, the objectives of State services are (1) to maximise the
rents accruing to the ruler and (2) reduce transactions costs to
enable output maximisation and thereby increase tax revenues
accruing to the State. Note her* that the neoclassical view of the
State as a maximiser of social welfare is completely
disregarded. also there is a clear divergence of interest between the
principal (the consumers) and the agent (the State).

Two factors lead to inefficient property rights: competition

from potential rivals for power and transactions costs. Under the
first, the State has to build up a support base to thwart the
ambitions of rivals, this is achieved by favouring powerful
constituents or interest groups, even if this results In
inefficiency. On the other hand, transactions costs associates with
metering, policing and collecting taxes provide incentives for
granting a monopoly. North (1981) concludes that "these two
constraints operating together account for the wide spread of
inefficient property rights. In effect the property rights
structure that will maximise the rents to the ruler is in
conflict with that that would produce economic growth" (p.28).

20
 7: INFORMATION THEORETIC APPROACH

The information-theoretic approach to economics (stiglits,

1994)provides an alternative approach to State intervention.
This approach is also based on market failures, but goes deeper
than the neo-classical approach. The neo-classical approach
merely identifies the various areas where markets fail and
these are seen as possible a anues for government intervention.
The transactions costs approach goes into detail regarding
the underlying causes of market failure and also indicates why
State Intervention is not all-pervasive. The information
theoretic approach also seeks to identify the underlying causes
of market failure, principally arising from the absence of
perfect Information; further, like the transactions costs
approach, limits on the extent of State intervention are
analysed.

The First Fundamental Theorem of Welfare Economics provides the

Intellectual foundations of the belief in market economies.
K B noted earlier, it states that, given certain assumption, a
competitive equilibrium is Pareto efficient. Competitive
equilibrium is understood to be a situation where supply
equals demand; if demand were not equal to supply, forces
would be set in motion which would change the situation,' so
that the original situation would not be one of equilibrium.
Recent work in economies with imperfect information has
established that competitive market equilibrium may be
characterised by demand exceeding supply (eg. Stiglitz-Weiss
(1981) models of credit rationing) or supply exceeding demand
(eg:Shapiro-Stiglitz (1984) model of unemployment with
efficiency wages). It may be noted that the term "competitive
market* refers to the situation where there are a large
number of participants on both sides, but ill which
information maybe imperfect (Stiglitz, 1994, p.285)

The Theorem assumes that there is perfect information and that

this information is fixed and that there is a complete set
of risk markets, Should this assumption not be satisfied, then
market may not be constrained Pareto efficient i.e. State
intervention may be unambiguously welfare improving. Thus one
would observe that there would be market failures associated with
information. This can be appreciated once it is realised that:
information has all the properties of a public good: non-rivalry
in consumption and non-exclusion or at least very costly
exclusion (Stiglitz, 1993). It is well-known that the market is
unable to provide a sufficient quantity of a public good,
including information: there would be under provision, of
information as well. Thus the optimal amount of information that
agents require to maximise -heir welfare would not be available
costlessly and agents may have to expend effort to gather
additional information. In standard neo-classical theory all the
information that an agent requires for decision making is
conveyed by the prices prevailing in the market. If agents are to
have an incentive to collect information beyond that conveyed by
prices, then this information should not be perfectly
disseminated in the market. If there were a complete set of
markets and if all information were conveyed by prices no agent
would spend any time, effort or money to acquire additional
information (Stiglitz, 1994).

Asymmetries of information may often limit the opportunities

for trading. If there is complete disclosure of information or as
In the standard neo-classical theory all information is conveyed
by prices, trading can be a positive sum game. However, with
asymmetric information the possibility of cheating (opportunism
or self interest seeking with guile in the terminology of
transactions costs economics) crops up and the trading situation
assumes the form of a Prisoner's Dilemma game. Such asymmetries Qt
information give rise to imperfections in many markets
including the insurance markets, futures markets, markets for
user cars, etc.

The problems of adverse selection and moral hazard arise out

Of situations of asymmetric information. The first problem
prevents firms from obtaining insurance on their profits: the

22
 firm knows its prospects better than the insurer and the insurer
fears that if the firm is willing to pay a premium, it is getting
too good a deal. Moral hazard also leads to limited' insurance:
the more comprehensive the coverage the leas incentives will
agents have to take countervailing actions to prevent the
insured-against event. Requiring complete insurance markets In
the presence of adverse selection and moral hazard will lead to
high premiums that will price out most agents. Thus insurance
markets will be thin and combined with transactions costs the
markets will be incomplete (Stiglitz, 1994). In the absence of
futures markets combined with incomplete risk markets, it is
conceivable that the economy can set off on. a path that is
locally inter-temporally efficient and only in the distant future
does it become evident that the economy is inefficient (Stiglitz,
1394, p.27). In such a situation State intervention, by
correcting for the inefficiencies arising out incomplete markets,
maybe unambiguously welfare enhancing

Standard neo-classical theory had a theory of State

intervention based on market failure: market failure due to
externalities and public goods, which called for a well-defined
role of the State. But an analysis of market failures based on
imperfect information seems to suggest that market failures are
pervasive in the economy. Should the government intervene to
correct all these market failures, one will necessarily have to
assume that the government is endowed with information that is
not available to the private sector; also the costs of
administering these interventions may well exceed the benefits of
the interventions. In the event it may be advisable for the
government to intervene only in those area where there are large
and important market failures, such as, insurance markets, risks
associated with job security and imperfections in the capital
markets. Solutions to the relatively less important market
failures may best be left to non-governmental initiatives.
However even such solutions will require governmental inputs; for
instance, the Coasian solution requires establishment of clear
property rights.

23
 CONCLUSIONS

We have in this paper reviewed four approaches towards a

rationale for State intervention. Each approach was
distinctive in terms of its view regarding:

1 . the role of the State or the rationale for State intervention

2 . the objectives of the State
3 . the relation of the State to the constituents of society
4 . the nature of the State

Table 8.1 below presents a summary account of the 4 points

lifted above and discussed in detail in the paper.

The neoclassical approach requires the pre-existence

of markets and the failure of some of these for the rationale
of State intervention to develop. The objective of the State in
each of its interventions is the same: maximisation of
social welfare.

According to the public choice approach the State cones

ii<to existence non-deliberately. However, the view of the
State and it« functionaries is rather more cynical as per
this approach then under the neoclassical approach. The
primary objective of State functionaries is the maximisation
of their own welfare. In view of this behavioural assumption
government failures are endemic and, by default, the market
is seen as being welfare enhancing since it limits the powers
of the State.

The transactions costs approach views the market and the

State as a means to an end, namely, the minimisation of
transactions costs. Thus the persistence of transactions costs
becomes the principal reason for the neoclassical market
failures as well as the principal reason for government
failure noted in the public choice approach. The
transactions costs approach

24
 TABLE 8.1 A COMPARISON OF VARIOUS APPROACHES TO STATE
INTERVENTION

APPROACHES TO Neo-classical Public Choice Transactions Information

STATE Costs Theoretic
INTERVENTION

BASIS OF
COMPARISON
Rationale Failure of pre- State arises Minimisation Failure of
for State existing spontaneously of markets
Interventio markets from a state transactions due to
n of nature costs imperfect
informati
on
Objectives of Maximisation of Maximisation of Combination Maximisatio
the State social welfare welfare of of neo- n of social
Stale classical welfare
functionaries and public
choice
approaches
Relation Consumers are State is the Combination Consumers
between State the principal; principal of neo- are the
and Stale is the classical principal;
constituents agent and public State is
of society choice the agent
approaches
View of the State Viewed to be Viewed Agnostic: Viewed to
benevolent variously as neither be
malevolent, consistentl benevolent
predator, y
revenue benevolent
maximising nor
malevolent
embraces both, neoclassical and public choice, approaches toward
state intervention. However, since the term "transactions coats
defines a precise definition and because of the generality of the
term, the efficacy of this approach in a real situation runs into
difficulty (Mueller, 1989, p,336).

Finally, the Information theoretic paradigm has a view of

the State that is similar to the one in the neoclassical
approach. The State intervenes in order to maximise social
welfare in response to market failures arising out of imperfect
information and because of incomplete risk markets. The crucial
difference between the neoclassical and information theoretic
approaches is that market failures are far more pervasive under
the latter than under the former. In the presence of imperfect
information the market would not be constrained Pareto efficient
and State intervention would be welfare enhancing. It must, of
course be noted that there will be government failures as
Stiglitz (1994) discussion on market socialism indicates; it is
also not at all certain whether "fair, wise and efficient
governments really exist for the "perfect* intrusive intervention
that is required by the information theoretic approach
(Jarami11o-Valejo, 1993),

In the final analysis the difference between the various

approaches towards state intervention stems from the view of the
State that is adopted. The neoclassical and information theoretic
approaches view the State as being essentially benevolent, having
as its primary objective the maximisation of social welfare. The
public choice views the State as being no different from the
other economic agents in society i.e. selfish and concerned with
maximising the welfare of State functionaries. Both of these
extreme viewpoints, however, run into difficulties. The
neoclassical approach runs into problems because the States are
not consistently benevolent; the public choice approach faces
difficulties because States do sometimes behave benevolently in
the sense of initiating policies, which curtail, their own power
in the interest of maximising social welfare.

26
 The transactions costs approach offers an escape from the
extreme positions that the other two approaches find themselves in
by being agnostic in its view of the State. The market and the
State are a means to an end, namely, minimisation of transactions
costs in the allocation of resources, and yet both may fail
leading to institutional failure. The major drawback of this
approach, as we noted earlier, is that no precise definition of
transactions costs exists which makes the concept nebulous and
difficult to pin down in a specific situation. In spite of this,
however, there is no denying the fact that the transactions costs
approach tells a very plausible story of State intervention.

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The aim of this series is to publish preliminary research
findings of the member of the faculty of the Department

Economics, University of Bombay. No part of thin

paper can be quoted or reproduced without the author's

written permission.

The List of Papers Already Published

1) Spectral Analysis of Non-stationary Time Series by D.M.

Nachane, Paper.no. September 95/1

2) Chaotic Economic Dynamics and Business Cycles by M.J.

Manohar Rao, Paper no. November 95/2

3) Farmers and Rulersi Stata Intervention in the 19th

Century Deccan Countryside by Nearaj Hatakar , Paper no.

96/J

4) Does Chaoa Imply Control 7 h Reaction to the Lucas

Critique by M.J. Manohar Rao, Paper no. December 9S/4

5) A Modified Hannan Inefficient Procedure for Causal

Systems by D.M. Nachane, Paper no. January 96/5

6) A Programme For Full Capacity Utilisation In the Indian

Manufacturing Sector by L.O. Burange, Paper no. February

96/6

7) Regional Trading Blocks and Their Implications For The

Indian economy by D.M, Nachane and Lakshmi R. , Paper no,

March 96/7

8) Promotional and protective Social Security During

Economic Reform Study of Two Indian States by K. Seat

Prabhu, Paper no. March 96/8

9) Financial Policy Coordination in a Keynesian Framework by

Romar Correa , Paper no. April 96/9

10) Industrial Reforms in' India* Experience and Prospects by

7.C. Sandesara Paper*'no. Kay 96/10

11) Theories of. State Intervention by Ajit Karnik, Paper, no

May 96/11

12) The Effectiveness of Fiscal Policy With a Tax Mix by

Errol D'Souza Paper no. June 96/12.

For copies and correspondence write to

Neeraj Hatekar

Department of Economic

University of Bombay

Vidyanagarl, Kalina,

Santacruz (East), Mumbai - 98

India.